1 Unless otherwise indicated, all section references are

to the Internal Revenue Code in effect for the taxable years in

issue. All Rule references are to the Tax Court Rules of

Practice and Procedure.

T.C. Memo. 1999-54

UNITED STATES TAX COURT

KARL T. HARVEY AND KATHLEEN S. HARVEY, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14541-97. Filed February 26, 1999.

Steven M. Cyr, for petitioners.

Ann M. Murphy, for respondent. 

MEMORANDUM OPINION

DINAN, Special Trial Judge: This case was submitted

pursuant to the provisions of section 7443A(b)(3) and Rules 180,

181, and 182.1
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Respondent determined deficiencies in petitioners' Federal

income taxes for 1992, 1993, and 1994 in the amounts of $3,682,

$1,733, and $3,129, respectively, and accuracy-related penalties

pursuant to section 6662(a) in the amounts of $736.40, $346.60,

and $625.80, respectively.

The issues for decision are: (1) Whether petitioners

received and failed to report constructive dividends during the

taxable years in issue; and (2) whether petitioners are liable

for the section 6662(a) accuracy-related penalties for the

taxable years in issue.

This case was submitted fully stipulated. The stipulations

of fact and attached exhibits are incorporated herein by this

reference. Petitioners resided in Phoenix, Arizona, on the date

the petition was filed in this case.

All of the substantive adjustments in the statutory notice

of deficiency relate to petitioners' shareholder interests in the

Kathy Harvey Trust Corporation (KHTC). Petitioners have operated

KHTC as a painting business since its incorporation on May 16,

1984. 

l. Constructive Dividends

The first issue for decision is whether petitioners received

and failed to report constructive dividends during the taxable

years in issue. Section 61(a) includes in gross income all

income from whatever source derived including, but not limited

to, dividends. Sec. 61(a)(7). 
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In the statutory notice of deficiency, respondent determined

that petitioners received and failed to report constructive

dividends from KHTC during 1992, 1993, and 1994 in the amounts of

$12,218, $11,301, and $10,851, respectively. KHTC's Federal

income tax returns reveal that it had ample earnings and profits

during the taxable years in issue to cover the amounts of

constructive dividends determined by respondent. The parties

have stipulated that the determined amounts consist of the

following:

 Dividends 1992 1993 1994

Forgone interest

 under sec. 7872 $7,984.67 $7,324.29 $8,472.41

Petitioners' personal

 expenses paid by KHTC 4,233.00 3,977.00 2,379.00

A. Forgone Interest Under Section 7872

KHTC advanced funds to petitioners before and during the

taxable years in issue. No loan documents were executed with

respect to the advanced funds. There is no evidence that

petitioners were obligated to pay or in fact paid any interest on

the advanced funds. Petitioners repaid some of the advanced

funds before and during the taxable years in issue.

Section 7872 sets forth the income and gift tax treatment

for certain categories of "below-market" loans; i.e., loans that

are interest free or that provide for interest that is lower than

the applicable Federal rate. Sec. 7872(e)(1); KTA-Tator, Inc. v.

Commissioner, 108 T.C. 100, 105 (1997); Mason v. Commissioner,

T.C. Memo. 1997-352. Pursuant to section 7872, a below-market
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loan is recharacterized as an arm's-length transaction in which

the lender made a loan to the borrower in exchange for a note

requiring the payment of interest at the applicable Federal rate. 

The amount by which the interest which would have been payable on

the loan at the applicable Federal rate exceeds the interest

payable pursuant to the loan agreement is called "forgone

interest". Sec. 7872(e)(2). The forgone interest is treated as: 

(1) Transferred from the lender to the borrower; and (2)

retransferred from the borrower to the lender as interest paid on

the loan. Sec. 7872(a)(1)(A) and (B). The first transfer is

treated as a gift, dividend, payment of compensation, or other

payment to the borrower, depending on the relationship between

the lender and the borrower. KTA-Tator, Inc. v. Commissioner,

supra at 102. The second transfer is treated as a payment of

interest by the borrower to the lender which is includable in the

lender's income and deductible by the borrower to the extent

allowable under section 163. Id.

Petitioners agree that the advances made by KHTC fall within

the section 7872(e)(1) definition of a below-market loan. They

contend, however, that respondent erred in determining the

amounts of the outstanding loans which were subject to section

7872 during the taxable years in issue. They argue that some of

the older loans were "unenforceable" during the taxable years in

issue by reason of Oregon's statute of limitation for commencing

actions upon a liability, effectively exempting such loans from

section 7872. Petitioners calculate that the correct amounts of
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their constructive dividends in the form of forgone interest for

1992, 1993, and 1994 are $8,310.81, $5,912.55, and $164.72,

respectively. Respondent argues that the Oregon law cited by

petitioners is irrelevant to the application of section 7872.

The Oregon statute of limitation relied upon by petitioners

generally requires that actions upon a contract or liability must

be commenced within 6 years. Or. Rev. Stat. sec. 12.080 (1997). 

However, petitioners stated in their petition to the Court that

the loans were substantially repaid as of April 14, 1997, several

years after the loans allegedly became "unenforceable" under

Oregon law. In addition, KHTC listed all of the outstanding

advances as loans to stockholders on the Schedules L (balance

sheets) of its Federal income tax returns. We conclude from this

record that petitioners treated all of the loans as valid debt

during the taxable years in issue. Moreover, we agree with

respondent's position that State law does not control whether

these outstanding loans are subject to section 7872. Morgan v.

Commissioner, 309 U.S. 78, 80 (1940); Burnet v. Harmel, 287 U.S.

103, 110 (1932); see also Estate of Arbury v. Commissioner, 93

T.C. 136, 148 (1989) where State usury laws did not limit the

fair market interest rate to an amount less than the federal

statutory rate. 

We have considered petitioners' other arguments with respect

to respondent's determinations of their constructive dividends in
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2 The two cases relied upon by petitioners in their

briefs are not related in any manner to the issue of whether the

loans in issue are subject to section 7872. See Genest v. John

Glenn Corp., 696 P.2d 1058 (Or. 1985); Delaney v. Taco Time

Intl., Inc., 681 P.2d 114 (Or. 1984).

the form of forgone interest and find them either irrelevant or

lacking merit.2 Respondent's determinations are sustained.

B. Petitioners' Personal Expenses Paid by KHTC

If a corporation pays for the personal expenses of its

shareholders, it is well established that the shareholders are

charged with additional distributions from the corporation,

taxable to them as dividend income if the corporation has

sufficient earnings and profits. Melvin v. Commissioner, 88 T.C.

63, 79 (1987), affd. per curiam 894 F.2d 1072 (9th Cir. 1990);

American Properties, Inc. v. Commissioner, 28 T.C. 1100, 1115

(1957), affd. 262 F.2d 150 (9th Cir. 1958).

In their petition, their opening brief, and their reply

brief, petitioners failed to address respondent's determinations

that they are properly charged with constructive dividends for

KHTC's payment of their personal expenses. The stipulations of

fact include only a bald assertion by petitioners that such

amounts were paid for business expenses. The only evidence in

the record related to these expenses is the revenue agent's

explanation of why he determined that the amounts paid for such

expenses constitute constructive dividends. 

Based on the record, we find that petitioners have failed to

prove any error in respondent's determinations that they are

properly charged with constructive dividends for KHTC's payment
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of their personal expenses during the taxable years in issue. We

hold that respondent's determinations are sustained.

2. Accuracy-Related Penalties

The second issue for decision is whether petitioners are

liable for the section 6662(a) accuracy-related penalties for the

taxable years in issue. Respondent's determinations of

negligence are presumed to be correct, and petitioners bear the

burden of proving that the penalties do not apply. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933); Bixby v.

Commissioner, 58 T.C. 757, 791-792 (1972).

Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment attributable to any one of various factors,

one of which is negligence or disregard of rules or regulations.

Sec. 6662(b)(1). Respondent determined that petitioners are

liable for accuracy-related penalties imposed by section 6662(a)

for the underpayments of tax for 1992, 1993, and 1994 because

such underpayments were due to negligence or disregard of rules

or regulations. "Negligence" includes a failure to make a

reasonable attempt to comply with the provisions of the Internal

Revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. "Disregard" includes any careless, reckless, or

intentional disregard of rules or regulations. Sec. 6662(c);

sec. 1.6662-3(b)(2), Income Tax Regs.

Section 6664(c)(1), however, provides that the penalty under

section 6662(a) shall not apply to any portion of an underpayment
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if it is shown that there was reasonable cause for the taxpayer's

position with respect to that portion and that the taxpayer acted

in good faith with respect to that portion. The determination of

whether a taxpayer acted with reasonable cause and in good faith

is made on a case-by-case basis, taking into account all the

pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income

Tax Regs. The most important factor is the extent of the

taxpayer's effort to assess his proper tax liability for the

year. Id.

Based on the record, we find that petitioners' underpayments

for 1992, 1993, and 1994 were not due to reasonable cause and

that they did not act in good faith. Accordingly, we hold that

petitioners are liable for the section 6662(a) accuracy-related

penalties for the taxable years in issue as determined by

respondent.

To reflect the foregoing,

Decision will be entered

for respondent.